Hypothetical Ethics Question (on Insider Trading and Duty to Clients)

CFA General
#1

Suppose your firm issued a Buy rating on XYZ security, a thinly traded stock, more than a year ago based on its own independent research. You have a client who requested to buy more of XYZ every few weeks since the recommendation until he accumulated a large position in XYZ.

Recently, your client ordered you to liquidate his entire position in XYZ. You initially refuse to do the order saying that the firm still has a Buy rating on it and that the sudden liquidation of such a large position will have adverse effects on capital markets. Your client still insists that you liquidate it all and you comply with his order (although his strange request raised some eybrows.)

So you sell all of this client’s shares of XYZ that day… the price of XYZ plunges 10%. The next day, bargain seekers buy back XYZ and it rallies 8%. The day after that, XYZ drops over 50% due to a scandal finally hitting the news. A week later, you are notified by the SEC that your client had possession of insider information regarding XYZ.

In this situation, have you violated any of the Codes and Standards?

#2

No, if you acted in good faith on your clients directives, and had no reason to expect that the client is acting on inside information, you have not violated ethical standards.

The tricky question is what do you do if you receive an order to buy or sell from your client and you happen to know that your client is in possession of and acting on insider information. I don’t think the standards of practice cover that situation. Legally, you may be liable for conspiracy for insider trading, and you may have an obligation not to do it, and the standards to require you to follow local laws on this sort of thing, but presumably there has to be some kind of standard for knowing that the information is illegal to use, plus a standard for knowing that that information is in fact the motivation for your client’s decision.

I guess one just hopes that one never finds oneself in that situation, or - if you do - there is sufficient plausible deniability that you weren’t certain and gave your client the benefit of the doubt.